Environment
This Stable Value Stock Is Built to Weather Market Storms
January 17, 2019
•6 min read
It is hard to say anything about McKesson
The pharmaceutical distributor should earn around $15 in 2020 and will IPO its technology business, which will unlock another $20-30 of value. McKesson stock is not just cheap — it’s incredibly cheap. If we take the current $127 price and take out $25 for the technology business, we are paying about $100 for $15 of earnings — less than 7 times.
Each business has an internal business cycle. Sometimes it is linked to the economy — such businesses are usually called “cyclical.” Others have internal industry dynamics that have nothing to do with the economy.
McKesson, for example, benefited tremendously when billions of dollars worth of branded drugs lost their patents and went generic between 2009 and 2015.
This wave of profitability impacted McKesson shares. Increased profitability of generics brought new, smaller competition in the generics space, attracted by a larger profit pie. The competitive dynamics of drug distributors had not really changed much, but McKesson and other distributors were overearning — their margins were too high. Growing revenues and expanding margins resulted in tremendous earnings growth, which brought “growthy” investors into McKesson’s shareholder base. As the generics wave sagged, McKesson’s margins declined to their normal level and so did earnings. These new shareholders fled, driving the stock down.
That is when we bought the stock. Since then the market has new worries about the stock. One is that Amazon.com
Here is a brief summary of the issue. Let’s say Pfizer
No insurer or consumer pays list price — well, kind of. The list price doesn’t matter much when many consumers have perhaps a $20 copay for any drug and don’t have health savings accounts (HSA) or high-deductible copays that are tied to the $100 (inflated) price, not the real $60 price. That $100 list price is under attack.
McKesson and other distributors are paid a fee by Pfizer to distribute the new drug, based on the $100 price. Pfizer pays McKesson a 4% fee on the $100, that is, $4. But political winds are now blowing against this ambiguous drug industry pricing. Mr. Market is concerned about what happens to the $4 if McKesson’s fee will now be tied to the $60 price instead of $100: Will the fee drop to $2.40?
To answer this question, we have to look at history, back to 2001. At that time, branded manufacturers paid drug distributors for their services by allowing the distributors to buy drugs before price increases went into effect. If Pfizer were going to raise a drug’s price by 4% next month, for example, it would sell the drug to McKesson for $100 today, and McKesson would hold it for a month and realize a $4 profit when it sold it to pharmacies for $104 a month later.
This arrangement worked well until a few drug companies started to abuse the system by stuffing drug distributors’ channels with too many drugs. Let me explain the process: Let’s say normal quarterly demand for Bristol-Myers Squibb’s
So, instead of “disappointing” Wall Street, Bristol-Myers Squibb would send 5 million extra doses of Plavix to distributors, stuffing distributors’ inventories but reaping an extra $500 million in sales on shipment. Distributors were happy to oblige, because BMY kept raising prices twice a year, and thus the larger inventory meant higher profitability. The problem is that by sending the extra 5 million doses, BMY borrowed from future demand. Distributors would participate in this game for a few quarters, but drugs are not fine wine — they don’t get better with age. If distributors buy too much Plavix, they run a risk of holding expired pills. So, after a few quarters, distributors would stop buying Plavix, causing its sales to fall off the cliff.
In 2004 Bristol-Myers Squibb paid a $150 million fine for stuffing distributors’ channels with $1.5 billion worth of drugs, and the pharmaceutical industry was forced to change how it pays for drug distribution.
As things now stand, pharma companies need distributors, but pharma companies lack the scale to distribute their drugs to thousands of pharmacies. Also, logistics and distribution lie far outside their core expertise. I remember in mid-2000 there was a lot of uncertainty about how distributors were going to get paid. At the time I recall our firm owned McKesson’s competitor Cardinal Health
There’s no reason to believe that this time will be different — the service that distributors provide is as important today as it was then, and the industry’s structure has not changed, either — three distributors control over 90% of the market.
The overhang from Washington on wholesale pricing does create uncertainty, and the math of how the industry comes up with that $4 is problematic, but it is unlikely to turn into a number less than $4.
Let’s not stop there. Let’s assume that this time is different. Let’s assume that $4 goes to a lower number. What impact would that have on a drug distributor? About 70% of McKesson’s revenue comes from branded drugs, but these have lower margins than generic drugs and thus bring only around 30% of profits. So, if $4 goes to $2.40, then McKesson’s earnings would decline about 18%, from $15 to around $12. This worst-case, low-probability scenario reduces McKesson’s earnings power and thus its fair value from $250 to $200. Which brings us to the essence of value investing: heads we win, tails we get less, but we still win.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly in-depth article.
Vitaliy Katsenelson is the CEO at Investment Management Associates, which is anything but your average investment firm. (Seriously, take a look.)
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Vitaliy Katsenelson
Vitaliy is Chief Investment Officer at Investment Management Associates, Inc (IMA), a value investment firm based in Denver, Colorado. Vitaliy joined IMA in 1997. He received both his bachelor of science and master of science degrees in finance from the University of Colorado at Denver.
He is the author of two books, and his articles have appeared in Barron’s, The Financial Times, and Business Week, among others. Vitaliy has been a guest on CNBC, Fox Business, BNN and Yahoo! Finance.
He also writes a monthly column for Institutional Investor magazine and speaks to investor organizations in the U.S. and abroad. Vitaliy has close to 20 years of investment experience and has taught a graduate investment class at the University of Colorado at Denver.
Vitaliy is a CFA Charter Holder and has served on the board of the CFA Society of Colorado. Forbes Magazine called him “The new Benjamin Graham“. You can read more of his writing at Contrarian Edge.
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